A Tractable Model of Precautionary Reserves, Net Foreign Assets, or Sovereign Wealth Funds

Working Paper
October 2009

The authors model the motives for residents of a country to hold foreign assets, including the precautionary motive that has been omitted from much previous literature as intractable. Their model captures many of the principal insights from the existing specialized literature on the precautionary motive, deriving a convenient formula for the economy's target value of assets. The target is the level of assets that balances impatience, prudence, risk, intertemporal substitution, and the rate of return. They use the model to shed light on two topical questions: the "upstream" flows of capital from developing countries to advanced countries and the long-run impact of resorbing global financial imbalances.